Thursday, July 10, 2008

Oil Speculation Explained

How can speculation in the futures market affect spot prices? This is a question I’ve asked several times over the past few weeks. I was doubtful that this could occur, because in a futures market, the futures price is based on the spot price (and a couple of other things—interest rates, the cost of storage, and for commodities, the convenience yield). I heard several convincing explanations why futures speculation couldn’t affect current spot prices (without lots of secret hoarding), but none from the speculation fear-mongers about how this was occurring, which it seems incumbent on them to explain. Especially since, as we have seen, they want laws enacted to stop or curtail the process.

Finally, I found a piece that carefully explains how speculation occurs in the oil market—and why futures prices are decoupled from spot. The blog-post, on the blog Peak Oil Debunked, is well worth reading in its entirety. It is a well-sourced, clear explanation. (And all you peak oil peoples, don’t be put off by the name of this person’s blog—the post has nothing to do with peak oil per se, and neither supports nor debunks it.)

To put it in a nutshell, when the price of oil is quoted, it is quoted either as West Texas Intermediate (WTI), Brent Crude, and Oman-Dubai. These three are very specific grades of oil. However, when a refiner buys oil from a producer, the refiner is going to get something rather different from WTI, Brent, or Dubai.

Most crude oil is traded based on long-term contracts, and the prices in those contracts are set by a system known as "formula pricing". In this system, the price of delivered crude is set by adding a premium to, or subtracting a discount from, certain benchmark or marker crudes…

Now a problem has arisen over time in that there isn’t enough WTI or Brent or Dubai oil actually being traded for the market in these grades of oil to be completely liquid. It’s possible to game those spot markets. This is done through a mechanism called a “squeeze.”

Low volumes of crude oil available for spot trading make price discovery problematic and increase the vulnerability of markets to squeezes, distorting prices and undermining market confidence. A squeeze refers to a situation in which a trader goes long in a forward market by an amount that exceeds the actual physical cargoes that can be loaded during that month. If successful, the squeezer will claim delivery from sellers who are short and will obtain cash settlement involving a premium. It is true that all markets are prone to squeezes and in the last few years there have been occasions on which the Brent market was subject to successful squeezes. But it is also true that it is easier to squeeze thinner markets.

Now since oil is priced based on a premium or discount from WTI, Brent, or Dubai spot, and WTI, Brent, and Dubai spot can be manipulated via squeezes, many exporters turned from basing their premia/discounts on spot to basing it on futures price (using some kind of formula for averaging futures prices).

Now we know that there are more futures contracts than physical oil. For one thing, lots of hedgers who use futures contracts are not actually in the business of buying and selling oil. Airlines, for example, hedge the price of fuel with crude oil futures. And, of course, there are speculators who use futures to make bets on the price of oil. This has exploded in the past few years, as capital has looked for a new place to live following the dotcom crash.

But what JD over at Peak Oil Debunked is saying is that all this activity in the futures market doesn’t come out in the wash—it actually ends up affecting the price of spot oil precisely because no one trusts the spot prices of WTI, Brent, and Dubai. Now I think the futures market for crude is too big to be manipulated, but it most certainly could be a bubble. And that bubble can then affect spot for actual (as opposed to benchmark) oil.

(This blog is interesting, and peak oil believers should read it to get another view. And JD is quite a mystery man—he provides no information about himself, except that he lives in Japan and his favorite book is "The Illusion of the End" Jean Baudrillard! You don’t find too many fans of French postmodern theory writing about oil…)